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PIMCO’s Gross: Don’t Abandon Ship in Turbulent Market

PIMCO bond manager Bill Gross is reassuring investors roiled by last week’s choppy markets that stocks and bonds are oversold and investors should stay the course.

In his new monthly investment outlook for July filled with nautical metaphors, the manager of the world’s largest bond fund says the yields reached on bonds in late April plumbed historic depths and needed correction, but the reaction to Federal Reserve Chairman Ben Bernanke’s tapering comments went overboard.

Perhaps that brush with fate got Gross, a former Navy lieutenant, to reflect on a near disaster that occurred when his ship came within one degree of heeling in the South China Sea. Gross and his fellow crewman survived, prompting the former chief engineer to advise investors on how to abandon ship when necessary but also on how to avoid panic and right the ship when indicated.

The U.S. economy is not sinking, Gross says. What happened last week was that investors reacted to a ship that was “top-heavy with too little ballast” because the Fed had “tilted overrisked investors to one side of an overloaded and overlevered boat.”

But Captain Gross says it would be a mistake for investors to jump overboard into “the cold money-market Atlantic Ocean at near zero degrees,” alluding to the Fed’s low policy rates.

That is because, far from the overreaction to Fed tapering of bond purchases, the central bank has consistently stated its 25 basis point federal funds rate will last beyond the end of QE, and “even then subject to a consistently strong economy that produces 2%+ inflation,” which Gross considers unlikely this decade.

Under these conditions, and with the fed funds rate as his guiding star, the Pimco captain argues that he can navigate the bond market by observing futures market predictions of fed funds, which show a 75-basis-point yield in 2015.

That makes current yields at the fed funds 25 basis-point rate a bargain: “If frontend curves are up to 50 basis points cheap, then intermediate curves—the 10-year Treasury—may be as much as 35 basis points too cheap. They belong in our opinion at 2.20% instead of 2.55%.”

In short, yield and risk spreads were far too low in April, but have overcorrected since. Captain Gross expects stock and bond returns in the 3% to 5% range in future years in an environment in which “those icy Atlantic money-market waters are likely to be with us for a long, long time.”

What lies ahead is hardly a luxury cruise, but the Pimco manager concludes that markets have managed to tack the boat windward again.